If you look at the Bank of Canada's official comments about the state of the Canadian economy and compare them to the U.S. Federal Reserve Board's pronouncements about the U.S. economy, you'll notice one major difference -- and no, it isn't the fact that Alan Greenspan spells "labour" without the "u." The big difference is that the Bank of Canada has an official inflation target, and the Fed has... well, nothing. And that says a lot about the nature of Mr. Greenspan's central bank.
In a nutshell, Mr. Greenspan likes to keep his cards close to his chest when it comes to which economic activity he is most concerned about and how he plans to achieve his goals. Is that because Mr. Greenspan enjoys being enigmatic? Or does he believe the Fed can be more effective that way? That's hard to say. What is clear is that many believe he is wrong, including some members of the Fed itself.
Since the early 1990s, the Bank of Canada has had an explicit annual inflation target of 2 per cent — the midway point of its target range or "band" of between 1 per cent and 3 per cent. When inflation gets too close to the upper or lower end of this range, the central bank decides whether to raise or lower its benchmark interest rate, in an attempt to either stimulate or slow down the pace of the economy's growth.
As the Bank of Canada describes it, monetary policy tied to an inflation-control target "tends to act as a growth stabilizer" by ensuring economic growth at a sustainable pace while "avoiding a recurrence of the inflationary boom-and-bust cycles of the early 1980s and 1990s." Maintaining a stable, low-inflation environment, the bank says, encourages long-term investment in future growth and job creation.
The U.S. central bank also believes that a stable, low-inflation environment encourages growth, but it has no explicit inflation target. Most economists and Fed-watchers assume that Mr. Greenspan would like to see inflation at about 2 per cent per year or below, but they don't know for sure because the bank has never actually said this.
According to the U.S. Federal Reserve Act, the bank's job is to "maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." There is no definition of what price stability means, or how to achieve it.
The U.S. Fed is the only major central bank without an inflation target. The Bank of New Zealand was the first to come out with an explicit target of between zero and 3 per cent in 1990 (the widest range of any central bank), followed quickly by the Bank of Canada and the central banks of the United Kingdom, Australia and Sweden. With the creation of the European Community came the European Central Bank, which also has an explicit inflation target range.
There have been several attempts to pass laws that would set a specific inflation target for the U.S. Fed -- in 1989, 1991, and 1993, and again in 1997 and 1999 -- but all have failed. Several Fed governors have also come out publicly in support of an explicit target, including former governor Laurence Meyer and current governor Ben Bernanke, but Mr. Greenspan has repeatedly resisted the change.
According to a speech by Mr. Meyer in 2001, the main reason for the opposition to an explicit target is that the U.S. Fed has a dual mandate. Its duty is not only to maintain price stability but to also achieve the maximum sustainable growth in the economy. Since these are to some extent mutually exclusive (that is, slowing the economy down to stop inflation decreases the chances of having higher growth) the Federal Reserve would rather have the flexibility to shift its focus or attention from one to the other as it sees fit.
As many point out, however, this makes the Fed a lot less transparent than other central banks, and increases the impression of inscrutability that Mr. Greenspan seems to encourage. Transparency is a key goal of central banks, Mr. Meyer says, because they try to influence the behaviour of buyers and sellers (or borrowers and lenders), and it is easier to do this over the longer term if these financial actors understand what the Federal Reserve is after.
Not that long ago, for example, Mr. Greenspan made comments that suggested he would not only cut rates aggressively but might actually buy long-term bonds to try and lower interest rates. In the end, the bank only cut rates by a quarter of a per cent, and in response, long-term interest rates actually rose -- the opposite of what Mr. Greenspan wanted to happen. In another case last year, the bank actually had to leak comments to the Washington Post to correct what it saw as a misinterpretation of Mr. Greenspan's comments about the economy's strength at the time.
Would an explicit inflation target remove the chances of that kind of miscommunication? Hardly. After all, the Bank of Canada has had its slip-ups as well -- and even an explicit target doesn't mean a central bank won't make the wrong decision (as some argue the Bank of Canada did when it raised rates earlier this year as a result of a spike in inflation). But it would make it easier to see which way the wind is blowing.
E-mail Mathew Ingram at mingram@globeandmail.ca
For past columns and a brief biography, click here
Look for exclusive commentary by Mathew Ingram at GlobeInvestorGold
© The Globe and Mail
Only GlobeinvestorGOLD combines the strength of powerful investing tools with the insight of The Globe and Mail.
Discover a wealth of investment information and and exclusive features.
